As mentioned in the preceding article, a country’s balance of payments is significantly impacted by its current account deficit. A country that has a current account deficit is one that is borrowing money from other nations or selling assets to pay for its investments and consumption. But this isn’t always bad for a nation’s economic performance.
Although a large current account deficit can lead to an increase in the interest rate and devaluation of the country’s currency, it can also indicate that the country is investing more than it is saving. This can lead to economic growth and more jobs. Therefore, there are factors which need to be considered while determining whether a country’s current account is good or bad for the economy.
The current account deficit of India is growing
The current account deficit of India has been growing for the last few years. In the second quarter of the fiscal year 2022-23, it stood at USD 36.4 billion, the highest in a decade (Bhat, 2022). This is largely due to:
- significant increase in oil prices,
- widening trade deficit,
- fall in remittances and,
- a steady decline in the services sector.
India’s dependence on oil imports, which account for a large share of its import bill, has made it vulnerable to fluctuations in global oil prices. Additionally, the country has been facing a widening trade deficit due to a combination of factors such as a stronger US dollar and rising imports of non-essential items. Other reasons for India’s rising current account deficit are as follows.
- Capital outflows: India’s large current account deficit has attracted foreign investors, but its capital outflows have increased too. For the period Oct 2021- June 2022 stood the net capital outflows stood at $36.5 billion, the highest since the 2008 recession (Singh, 2022).
- Service sector: The service sector, which traditionally has been a major source of foreign exchange for India, has been hit by the COVID-19 pandemic leading to a decline in the service balance and an increase in the current account deficit. The service sector’s share in India’s Gross Value Added (GVA) declined from 55 per cent in 2019-20 to 53 per cent in 2021-22 (India Budget, 2022).
- Remittances: India receives a large amount of money from its citizens working abroad as remittances, which has been affected by the global economic situation due to the pandemic, leading to a decline in remittances and an increase in the current account deficit.
Impact of a growing deficit on the economy of India
In the past, a higher current account deficit can have profound implications on an economy. In the case of India, the rising deficit is likely to have the following impact on the Indian economy in the coming years (IAS Score, 2022; Mishra, 2022):
- Higher interest rates: A large and sustained current account deficit can lead to a buildup of debt and an increase in interest rates, which can make it more expensive for businesses and consumers to borrow money.
- Devaluation of currency: A large current account deficit can also lead to a devaluation of the Indian rupee, making exports more expensive and imports cheaper. This can hurt domestic producers and benefit importers, leading to a trade imbalance.
- Capital outflow: A widening current account deficit can raise concerns among investors, which can lead to capital outflows and a fall in the value of the rupee, making the country less attractive to foreign investment.
- Inflation: Rising imports can lead to higher imported inflation, causing an increase in overall inflation as well. This will cause volatility in the domestic market.
- Depletion of foreign reserves: A high current account deficit can also lead to a decrease in foreign exchange reserves and make the country more vulnerable to external economic shocks.
A high current account deficit can be beneficial
There is substantial evidence showing that a current account deficit can have good and bad effects on an economy. Kose and Prasad (2009) found that a high deficit can be beneficial for an economy in the short term as it can lead to an increase in investment and economic growth.
However, the authors also found that a high current account deficit can lead to a decrease in foreign exchange reserves. Moreover, a high deficit can be beneficial for a country’s economic growth in the long term, as long as it is financed by foreign direct investment rather than debt (Nayak, 2012).
The authors also found that foreign direct investment can help to increase exports and decrease imports, as a result reducing the current account deficit. In conclusion, a high current account deficit can be both good and bad for an economy depending on the circumstances and the policy measures taken to address it.
- Bhat, S. (2022) ‘India’s current account gap widens to 9-year high’, Reuters, 29 December. Available at: https://www.reuters.com/world/india/indias-currentaccount-gap-widens-9-year-high-2022-12-29/.
- IAS Score (2022) Implications of Rising Current Account Deficit on Indian economy, IAS Score.
- India Budget (2022) Economic Survey 2021- 22, Services sector.
- Kose, A. and Prasad, E. (2009) ‘Does openness to international financial flows raise productivity growth?’, Journal of International Money and Finance, 28(4), pp. 554–580.
- Mishra, R. (2022) ‘India’s current account deficit is rising. What implications does it have for Indian economy?’, Business Today, 26 September.
- Nayak, G. (2012) ‘ET in the classroom: Funding of current account deficit’, The Economic Times, 21 December.
- Singh, K. (2022) ‘Why the Recent Massive Outflow of Capital Matters for India’, The Wire. Available at: https://thewire.in/economy/capital-outflow-equity-market-foreign-investment.